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Real Estate Investment Trust Outlook - July 2012 - Industry Outlook

The U.S. Real Estate Investment Trust (REIT) industry continued
its bull run in the first half of 2012, driven by strengthening
fundamentals for commercial real estate and an improving outlook
for the U.S. economy despite some recent doubts. The uptrend in the
diffusion index further suggested that economic growth was
broadening across sectors and indicated a higher probability of a
firmer foundation for future growth.

Equity prices moved northwards as geopolitical noise remained
relatively benign with a controlled restructuring of the Greek debt
and additional liquidity provided to European banks, thereby
reducing a potential threat to the global financial system.

The Fed maintained a low rate of interest and even promised to keep
it there through late 2014 to sustain the economic recovery. With
expected GDP growth of around 2% in 2012, positive vibes were
emanating from the overall industry. Employment data was also
encouraging, with an average monthly gain of 226,000 for the first
quarter of the year.

However, with escalation of the European debt crisis and emerging
signs of economic weakness all over the world, average employment
growth dropped to a mere 75,000 per month during the second quarter
of 2012. This pegged back the growth momentum to some extent as
speculation of a sovereign debt crisis in Europe weighed on
investors.

Nevertheless, the U.S. REIT industry outperformed the broader
equity market in the first half of 2012. The FTSE NAREIT All Equity
REIT Index reported total returns of 16.11% as of July 2, 2012 vs.
a 13.28% and 8.58% for the NASDAQ Composite, and the S&P 500
Index, respectively.

A combination of factors has helped the listed REIT sector to stand
out and gain critical mass over the past 15 to 20 years, the most
notable among them being a healthy dividend payout. Total returns
of 16.11% for the FTSE NAREIT All Equity REIT Index in the first
half of 2012 included a share price return of 14.12%.

Investors looking for high dividend yields have historically
favored the REIT sector. Solid dividend payouts are arguably the
biggest enticement for REIT investors as U.S. law requires REITs to
distribute 90% of their annual taxable income in the form of
dividends to shareholders. The dividend yield for the FTSE NAREIT
All Equity REIT Index as of July 2, 2012 was 3.25%, compared to
1.58% for the 10-year U.S. Treasury Note.

During 2007 to 2009, REITs took on far less debt than private real
estate investors, and many were able to sell at the top of the
market when private equity investors were still buying.
Importantly, during the downturn, REITs were able to acquire
properties from highly leveraged investors at deeply discounted
prices. This enabled them to add premium high-return assets to
their portfolios.

Furthermore, REITs managed to raise capital to pay off debt, owing
to a large inflow of funds as institutional investors allocated
more 'dry powder' to the industry, making them an increasingly
attractive investment proposition. In 2011, REITs raised $51.3
billion in public equity and debt, out of which $37.5 billion alone
was raised though public equity despite a highly volatile market.
During the first quarter of 2012, publicly traded U.S. REITs raised
an aggregate of $21.2 billion in capital, which included $10.6
billion in equity.

Moreover, according to data from NAREIT, debt ratio of equity REITs
(total industry debt as a percentage of its total debt and equity
market capitalization) as of December 31, 2011 was 38.6% --
significantly lower than 51% at the end of second quarter 2008,
which was prior to the Lehman Brothers collapse and the 'Great
Recession.'

In addition, REITs typically have a large unencumbered pool of
assets, which could provide an additional avenue to raise cash
during a crisis. These, in turn, have provided the requisite
wherewithal to the REIT industry to make strategic acquisitions
over time to fuel its inorganic growth engine. Moving forward, the
REIT industry is likely to maintain the uptrend in growth for the
remainder of 2012. The outlook remains by and large positive.

However, given the positive note in the investor sentiment, a
number of factors still persist as a thorn in the improved market
scenario. As it is is a presidential election year, chances are
high that the U.S. policymakers will refrain from making any
radical changes on key issues. With political uncertainty
persisting until at least the elections are over, investors might
play a 'wait and see' game before committing on better investment
opportunities. This could, in turn, put a ceiling on equity returns
in the latter half of 2012.

Furthermore, the strategic move to focus on austerity measures
among European countries could impede regional economic growth,
leading to a dearth of investor confidence in the European
financial and fiscal system. In addition, economic growth in
emerging markets, particularly the BRIC countries, is expected to
be lesser than in recent years, driven by a relative weakness in
the developed world and related uncertainties in the global
business climate. All these factors could cumulatively contribute
to an equity market headwind in the remainder of 2012.

In a nutshell, the long-term prospect of the REIT industry looks
favorable with a mild cautionary note. Year to date, the standout
performance in the industry was that of the Regional Mall REITs (a
total return of 24.42% as measured by the FTSE NAREIT Equity REIT
Index), followed by Mixed (22.54%), Shopping Centers (20.49%) and
Industrial REITs (19.73%). The relatively underperforming sectors
were Apartments (10.82%), Manufactured Homes (11.36%) and Self
Storage REITs (12.69%).

OPPORTUNITIES

We are bullish on
Taubman Centers Inc.
(
TCO
) which owns, develops, acquires and operates regional and
super-regional shopping centers throughout the U.S. and Asia.
(Retail shopping centers spanning over 400,000 square feet of gross
leaseable area [GLA] are generally referred to as regional shopping
centers, while those centers having in excess of 800,000 square
feet of GLA are generally referred to as super-regional shopping
centers.)

Taubman focuses on dominant retail malls that command the highest
average sales productivity in the U.S., measured in terms of mall
tenants' average sales per square foot. During the first quarter of
2012, mall tenant sales per square foot improved 13.3%
year-over-year, bringing the tally on a 12-month trailing basis to
$659.

Furthermore, the shopping centers are located in the most affluent
regions of the country, thereby enabling retailers to target
high-end upscale customers and maximize their profitability. This,
in turn, has enabled Taubman to command relatively premium rents
for its portfolio, thereby ensuring a steady top-line growth.

In addition, Taubman has one of the strongest balance sheets in the
sector with adequate liquidity. The company has also taken prudent
steps to reduce operating expenses by pruning its pre-development
spending in the U.S. and Asia, as well as significantly reducing
its overall workforce. This, in turn, has improved the bottom line
of the company.

We also remain bullish on
PS Business Parks, Inc.
(
PSB
), which owns, acquires, develops and operates commercial real
estate properties such as low-rise suburban multi-tenant offices,
business parks and industrial and flex assets. Located mostly in
high-population markets, flex properties are a combination of
warehouse and office space and can be easily configured to suit a
variety of uses.

The warehouse component of the flex space is primarily used for
purposes such as light manufacturing and assembly, storage and
warehousing, showroom, laboratory, distribution and research and
development activities. The office component of the flex space is
complementary to the warehouse component, and enables businesses to
accommodate management and production staff in the same facility.

PS Business Parks invests and owns commercial real estate
properties in diversified markets that enables it to tap multiple
industry concentrations and neutralize the operating risks
associated with economic down-cycles. Consequently, the company has
a relatively steady revenue stream.

The company also seeks to maximize its cash flow by controlling
capital expenditures associated with re-leasing space by acquiring
and owning properties that can be easily reconfigured and suit a
variety of uses. This, in turn, attracts a wide variety of tenants
and provides it with operating flexibility to protect and enhance
market positions by capitalizing on improving real estate market
fundamentals.

Another stock worth mentioning is
Prologis Inc.
(
PLD
), which acquires, develops, operates and manages industrial real
estate space in North America, Asia and Europe. Prologis had merged
with the erstwhile namesake company in an all-stock deal to become
a behemoth of sorts in the industrial real estate sector.

The combined entity had brought two of the most complementary
customer franchises on the same platform and created a $44 billion
asset pool at their disposal at the time of the merger. The merger
had led to potential cost savings through operational synergies and
had created a stronger platform for value creation and sustainable
growth in the long term.

In addition, Prologis provides industrial distribution warehouse
space in some of the busiest distribution markets across the globe.
The properties of the company are typically located in large,
supply-constrained infill markets at close proximity to airports,
seaports and ground transportation facilities, which enable rapid
distribution of customers' products. This has enabled the company
to gain a significant pricing advantage over its competitors.

WEAKNESSES

A significant chunk of REITs are raising capital through property
level debt and equity offerings. Although both debt and equity
financings provide the much-needed cash infusion, they could
potentially burden an already leveraged balance sheet and dilute
earnings. Property level debt is also harder to obtain and more
expensive, as commercial real estate prices remain under pressure.

Although overall market fundamentals remain positive for Apartment
REITs, we are a tad bearish on
Apartment Investment and Management Company
(
AIV
), or Aimco as it is popularly known. Aimco is one of the largest
owners and operators of multifamily apartments in the U.S., with a
strong portfolio of Class 'B' and Class 'C' properties primarily
catering to the middle-income market.

The company is currently restructuring its portfolio and expects to
sell almost all of its affordable properties over the next four- to
five-year period, in order to concentrate entirely on the
conventional real estate portfolio. Aimco also expects to reduce
its investment in non-target markets and consequently increase its
investment in target markets through redevelopment and
acquisitions.

Despite attempts to reposition its portfolio, much of it still
resides in areas where housing is relatively cheap. As the company
continues to sell non-core assets and buy in higher growth, infill
areas, we expect continued earnings dilution.

We also remain skeptical on
Public Storage
(
PSA
), the largest owner and operator of storage facilities in the U.S.
Public Storage operates in a highly fragmented market in the U.S.,
with intense competition from numerous private regional and local
operators. This has affected its profitability to some extent.

In addition, demand for storage facilities has witnessed a
significant fall from its peak level exhibited prior to the
recession, as customers have reduced their discretionary spending.
To add to the woes, Public Storage has significant exposure to
Florida. Florida's economy has been particularly hard-hit by the
housing meltdown, and the demand for self-storage facilities is
expected to diminish with fewer home sales and falling new home
construction.

Moving forward, limited supply of new construction, coupled with
the growing demand for high-quality properties, bode well for the
earnings prospects of REITs, in particular those that have assets
in high-barriers-to-entry markets. To sum up, we firmly believe
that despite a few pitfalls, REITs still make a worthy investment
proposition during the second half of 2012.

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